What exactly is a full ratchet?
Full ratchet protects early investors in contracts. A company’s anti-dilution clause applies to shares sold after issuing an option or convertible security, using the lowest sale price as the adjusted option price or conversion ratio for existing shareholders.
Knowing Full Ratchets
A full ratchet protects early-stage investors from losing ownership in subsequent fundraising rounds. This feature protects costs if future rounds are cheaper than the first.
However, there are restrictions. Offering these assurances to early-stage investors can be costly for firm founders or later-stage investors.
A complete ratchet provision can make it hard for the corporation to raise further funds. For this reason, full ratchet provisions are usually only in effect temporarily.
Full Ratchet Example
Example: A corporation sells 1 million convertible preferred shares at $1.00 each, with full ratchet provisions. Imagine a second funding round where the corporation sells 1 million common shares at $0.50 each.
The full ratchet provision requires the corporation to lower the conversion price of preferred shareholders’ shares to $0.50. The preferred shareholders would need fresh shares (at no cost) to ensure that the sale of the new ordinary shares does not reduce their ownership.
This dynamic can require additional shares to satisfy the original preferred shareholders (who benefit from the full ratchet provision) and new investors who want a set proportion of the company. Investors want a percentage of ownership, not just a quantity of shares.
The back-and-forth modifications favoring old and new investors can quickly reduce firm founders’ ownership holdings.
Comparing Full Ratchet with Weighted Average
A weighted average provision may better balance founders, early investors, and later investors. This technique has two types: narrow-based and broad-based weighted averages.
- Full ratchets reduce dilution by using the lowest sale price as the modified option price or conversion ratio for existing owners.
- It compensates early investors for future fundraising dilution.
- Full ratchets provisions can cost entrepreneurs and hinder future fundraising.
- Weighted average arrangements are popular alternatives to full ratchets.